JPMorgan shows fighting complexity is futile - FT.

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May 23, 2012 7:26 pm

By Sallie Krawcheck

There has been much ink spilled on the $2bn and counting JPMorgan trading loss: what happened, how it happened, who made the trade, who agreed the trade, whether the Volcker rule would have prevented the loss and whether such a loss should even be of concern given the size of the banks balance sheet. Much of this commentary misses a crucial point: the size and risk of the trading position was identified to the management team by an outside party (the press) and once highlighted, it took weeks for them to understand and quantify the loss. This occurred despite JPMorgan being run by one of the financial sectors savviest management teams. This should put to rest Wall Streets emerging narrative for explaining the downturn of the past five years: that the chief executives of the large financial institutions in 2007 were somehow, each in his own way, lacking. One was viewed as not smart enough, another was too emotionally invested in his company, another did not have the right background for the job. By having the right CEOs in the jobs, so the story goes, the downturn could have been avoided, and the Dodd-Frank reforms safely contested. Instead, JPMorgans trading loss points to the challenge of managing and regulating these incredibly complex companies. It is complexity that in good part defines Wall Street and forms some of finances highest barriers to entry. These are companies that do not benefit greatly from traditional barriers to entry, such as patents or copyrights. New capital is not typically a barrier new players have readily supplied it when others have retreated. Talent is mobile, moving seamlessly from one bank to another. It is complexity that over time has proved the highest hurdle. If other companies cant understand your product or trading strategy, they cant copy it, and excess returns can be sustained. The JPMorgan loss demonstrated once again that risk measurements have struggled to keep up with complexity. In this case, so-called value at risk calculations did not keep the management team well apprised of the amount of risk in the trade and the severity of the losses. These calculations are only as good as the banks inputs and internal risk models. In the main, the response from regulators to the perceived causes of the downturn has been

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JPMorgan shows fighting complexity is futile - FT.com

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to fight complexity with complexity. With the Volcker rule banning proprietary trading, there appears to be an implicit perspective that the source of risk matters. In other words, the idea that a proprietary trading loss is in some way more painful than losses on, say, mortgage loans or litigation. I would guess that shareholders, depositors and even US taxpayers would find loan losses that caused a big bank insolvency to be every bit as painful as one caused by proprietary trading. And even assuming that proprietary trading losses are more idiosyncratically painful, those who have spent any time in or around Wall Street understand that identifying a trade as proprietary is a fruitless exercise. The line between proprietary trading, client facilitation and hedging is so thin as to be often nonexistent. If regulators engage with the banks and regulate topic by topic to stop this exact scenario from repeating itself Wall Street will innovate businesses and trades that overtake their efforts every time, in search of new pools of profitability. Instead, regulators should turn their attention to the issue of understanding how much risk the banks are taking in total, fixing the measurements of risk that have fallen short and then making certain that banks have enough capital to support that risk. The JPMorgan loss also provides the regulators with a real-world opportunity to assess one of their most important initiatives, stress tests. Where did they fall short, if they did? Regulators should also complete the unfinished business of re-regulating the credit rating agencies, so that they can be confident they have an unbiased partner in assessing bank risk. While rating agencies intentions are no doubt very good, any business being paid by the Wall Street firms themselves risks, over time, working for the master who pays them. And regulators should be candid with themselves. Easy to say, hard to do. If their assessment is that their risk models and stress tests are unable to keep up with the complexity of certain types of trades or sub-businesses, then the activities should not be allowed in a regulated banking entity. Full stop. We need to shift the conversation in a fundamental way. We must discuss how much risk, of any kind, we are comfortable having our banks shoulder, rather than playing the proprietarytrading parlour game. A lot of work is still to be done on bank risk, but in a world in which bank runs can happen with amazing rapidity, with a few clicks of the computer mouse in the middle of the night, by a shaky public the stakes have never been so high. The JPMorgan loss serves as a warning sign to make certain that we are fighting the right battles.

The writer is former head of Merrill Lynch wealth management

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JPMorgan shows fighting complexity is futile - FT.com

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